- It's important to account for taxes when you're retired and on a fixed income.
- You may end up owing the IRS less tax as a retiree, but don't count on that.
Things could shift in your favor -- or not.
If there's one thing workers and retirees have in common, it's that nobody likes paying taxes. And if you're nearing retirement, it's important to understand the ways your tax situation might change once your career comes to an end. Here are some shifts to look out for.
1. You may land in a lower tax bracket
The U.S. tax system is a marginal one that has you paying a higher rate of tax on your highest dollars of earnings. As such, your marginal tax rate is not the same thing as your effective tax rate. If you're in the 22% tax bracket, you pay that much federal income tax on your highest dollars of income, but you won't necessarily pay 22% on your income overall.
With that said, once you retire, you may find that you end up in a lower tax bracket than you fell into while you were working. And the reason might boil down to not having as much income. That means when you take withdrawals from a retirement account, you may not have to allocate as high a percentage to the IRS as you did from your former job-related paychecks.
2. You may land in a higher tax bracket
Some people have less income in retirement than they did when they worked. But that's not guaranteed to happen. If you have a large IRA balance and are entitled to a generous monthly Social Security benefit, your income might surpass the amount you earned at the end of your career. That could, in turn, bump you into a higher tax bracket.
3. You may lose the ability to claim certain deductions
Tax deductions serve the very important purpose of exempting part of your income from taxes. If you're entitled to a $5,000 tax deduction, it means the IRS won't tax you on that portion of your earnings.
But once you retire, you may not be able to claim the same number of deductions you claimed when you were working. For example, you can deduct IRA contributions on your taxes. But if you're retired and are therefore not making IRA contributions, that's one less deduction to benefit from.
Similarly, many people enter retirement with their mortgages paid off. Shedding that monthly expense is a good thing. But it also means not being able to deduct mortgage interest on your taxes. Granted, that deduction only comes into play when you itemize on your tax return (whereas you can claim an IRA deduction whether you take the standard deduction or itemize), but it's something to be aware of nonetheless.
Prepare for tax changes
Taxes could play a big role in your retirement finances, and yours might change a lot once you stop working for good. It pays to sit down with a tax professional ahead of retirement so you know what to expect. A tax professional can also help you devise some strategies that leave you paying the IRS less -- and hanging onto more of your money.
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